Faculty sessional meeting - Credit derivatives

Paul Fulcher presented the main themes of the paper ‘Credit derivatives’ prepared by the Derivatives Working Party at the Faculty sessional meeting on 15 January in Glasgow. A number of fellows sat on a panel for the discussion (Gary Finkelstein, Paul Sweeting, Paul Coleman, and Euan Munro).

Credit derivatives – the paper

The paper prepared by the working party is intended as a general guide to credit derivatives. It looks at the current market and its development, some common instruments in the market (CDS – credit default swaps and CDO – collateralised default obligations, among others) and the regulatory impact of using such instruments.

The paper also touches on the issue of the ‘credit spread puzzle’ whereby credit-risky bonds appear to exhibit more spread than their default rates might suggest.

The presentation

Paul Fulcher described the CDS market and then went on to show how CDS are used as ‘building blocks’ in other contracts such as CDO. These instruments are becoming more common in the market and it was pointed out that the Financial Times on the day of the meeting reported that Northern Rock had used a CDO-type structure to finance part of its mortgage book.

It was explained that life companies might use CDS to gain or remove credit exposure on individual companies. CDS might also be used to separate the risks of interest rates and credit that traditional corporate bonds give.

CDOs give the possibility of yield enhancement, diversification, and potentially the ability to structure a hedge against credit losses between a lower and upper level – potentially useful for ICA-type hedging.

Some barriers to their use were listed as transparency, admissibility, and basis risk.

The presentation then touched briefly on the ‘credit spread puzzle’ and explained that various academic studies have failed to reach a firm conclusion on the make-up of a credit spread and how it varies with market conditions. Potential reasons for large credit spreads are systematic risk, a heavily skewed payoff, and liquidity risk. A common area of uncertainty is how much (if any) of the spread should be capitalised in the valuation of long-term illiquid liabilities, such as annuities.

Panel discussion

Questions were raised on a number of topics with contributors covering such issues as trading costs, the similarities between CDOs and split cap investment trusts, the risks of correlation of names within CDOs, diversification between credit and equity markets, and the ease of explanation to non-experts.

A question by the Faculty president instigated discussion about the use of credit derivatives within pension funds and even in the PPF.